Production costs represent the day-to-day costs of running an oil and gas field, with the vast majority of these costs being fixed. This has important implications for supply, as oil will continue to be pumped as long as production costs can be covered, and these production costs globally are estimated to be $15/boe4 for the world’s largest integrated oil producers (and lower for pure E&P companies). Importantly, this estimate excludes the OPEC national oil companies where it is estimated that production costs for some onshore fields are as low as $1-2/boe.3 Interestingly, given the high fixed cost structure, the most important element in lowering costs is volume itself (more barrels through the same cost base), putting further impetus on maximising near term production.
With investments in place and the not insubstantial costs of shutting down fields, it is not surprising that the focus is on maximising production and focusing on cash returns – resulting in significant overproduction and stock-building. Indeed the world has been over-producing oil every quarter from the beginning of 2014, with the degree of over-production rising rather than falling as the oil price has weakened. Specifically, since August 2014 (when oil was last over $100) to the end of October this year, global oil production has risen by 3.6mbbl/day. Interestingly, during this period the level of US shale oil production has risen by just 263k bbl/day, accounting for less than 10% of the overall increase. In fact the largest contributors to global supply growth over the last 14 months have been the OPEC nations of Iraq and Saudi Arabia, together with Russia, the US offshore Gulf of Mexico and Asia. Thus even if, as the IEA expects, US shale oil production falls by 600kbbl/day5 next year, this needs to be understood in the context of the world currently over-producing oil by 1.6mbbl/day, and where global inventories are at levels not seen for more than two decades.
This level of supply increase has had profound implications for the shape of the oil futures curve. The chart below depicts the shape of the current oil futures curve and how it has changed from August 2014 and since the start of this year.
Chart 1: Brent oil futures curves
Source: Argonaut, Bloomberg
The change into contango is clearly evident as supply pressures come on to the market, forcing spot prices lower. Whilst future prices are higher, the step change down is equally important, particularly when compared to what analysts are assuming and carrying in their models.
Table 2: Oil price implied by current futures curve vs current analyst assumptions
Source: Argonaut
Once again, analysts seem to be overly optimistic in their future oil price assumptions. The clear risk is the oil price continues to stay at current levels (or lower) over the near term. Oil producers will not cut production due to the economics, whilst Saudi Arabia (as the lowest cost producer) is unlikely to initiate production cuts either until it achieves some or all of its strategic aims. If we are correct, it means that the most important modelling assumption (the oil price) used by oil analysts is incorrect which would mean significant downward revisions to earnings expectations and thus valuations for the sector. Equally, it will mean that recent acquisitions done and debt issued based on budgeted higher oil price assumptions by investment banks may not be as economically viable as first thought – a veritable house of cards.
